Get set for a bumpy ride

There’s more than a little irony this year to the International Monetary Fund’s long-standing practice of holding its two flagship meetings in the northern hemisphere’s autumn and spring.

Just six months ago, the finance ministers and central bankers who attend these biannual soirees, with their cocktail parties and boozy official dinners, had a sunny outlook for the global economy.

But the onset of colder weather in the American capital, coupled with months of turmoil on global financial markets, has brought with it a darker and far more pessimistic assessment of where the world economy is heading.

IMF chief economist Olivier Blanchard told the gathering in April that the global recovery from the worst downturn since the Great Depression had “solidified", noting that earlier fears of a double-dip recession “have not materialised".

The Washington-based agency was upbeat enough to maintain its world growth forecasts for 2011 and 2012, and even went as far as nudging up its projection for advanced economies next year to 2.6 per cent from 2.5 per cent.

Fast forward by half a year and the IMF is now concerned that the global economy has entered a “dangerous new phase", warning that finance ministers and central bankers are running out of time and options to stimulate growth and prevent the world economy from shrinking.

“The recovery has weakened considerably and downside risks have increased sharply," Blanchard said this week after announcing the IMF had downgraded its forecast for global growth this year and next to 4 per cent, with projections slashed for both America and Europe.

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Citigroup expects global growth of just 3.1 per cent in 2011 and 3.2 per cent in the following 12 months, while HSBC is tipping 2.6 per cent this year and 2.8 per cent in 2012.

Gloomier still, Capital Economics has pencilled in a contraction in the euro zone of 0.5 per cent in 2012 and a fall of 1 per cent in 2013.

Economic conditions in the US and Europe are also getting worse rather than better, despite the US Federal Reserve’s recently announced Operation Twist and signs that the European Central Bank will start cutting interest rates again as early as next month.

Paul Ashworth at Capital Economics said the Fed’s action this week to “twist" the US Treasury curve would have “only a limited downward impact on longer-term interest rates and the impact on the wider economy will be even more modest. The big question is whether this latest action will accomplish anything? Frankly, we doubt it."

Across the pond, the outlook is similarly bleak.

“The problems in the euro area have deteriorated significantly and are likely to worsen further before stabilising," said Paul Robinson, head of foreign exchange research at Barclays Capital in London.

“Politicians across the euro area face an extraordinarily difficult job in convincing their electorates that strong action is in their interests and market participants that they are in control of the situation," he said. “Even if they are able to stabilise the problems, the first step will be a further deterioration."

Governments in advanced economies have been hamstrung in their policy responses to the deteriorating global outlook by an urgent need to get their debts under control and to demonstrate at least a semblance of fiscal responsibility.

Just as the world economy edges closer to the abyss, the IMF estimates that governments in the developed world will be embarking on a structural tightening in 2012 that will amount to about 1.25 per cent of their combined gross domestic product.

Jamie Dannhauser from Lombard Street Research in London reckons that will be “the biggest fiscal squeeze in at least 30 years".

Some economists claim that this sort of fiscal restraint won’t have a negative impact on global growth, suggesting instead that budgetary consolidation can actually stimulate private consumption and investment through a seemingly incongruous phenomenon known as “expansionary fiscal contraction" or “expansionary austerity".

Larry Summers, former US Treasury Secretary and the past director of President Barack Obama’s National Economics Council, says the concept is an “oxymoron."

So where does Australia stand in all of this? The Reserve Bank has so far been hedging its bets, with senior officials waiting for the dust to settle on the world’s turbulent equity markets before deciding what needs to be done.

“Nobody yet knows when, or how, the issues that are causing the financial turmoil will be resolved," the central bank’s hawkish deputy governor,
Ric Battellino
, said in a speech in New York this week.

But Battellino acknowledged that a topical question “is whether the recent turmoil in global markets will eventually overwhelm the positive effects on the Australian economy from China".

Some market economists have already begun crunching the numbers to try to get an answer to that very question.

Deutsche Bank has done some detailed modelling on the issue, although Australian chief economist Adam Boyton stresses it is simply a “scenario" and doesn’t represent the house view of the local research team.

The Deutsche scenario is based more or less on a rerun of the 2008-09 global recession, which led to contractions in real GDP in the US and Europe of 3 per cent.

That, in turn, led to Chinese economic growth easing to about 7 per cent, inducing a decline in Australia’s terms of trade of about 15 per cent.

Boyton says this will probably mean the Reserve Bank will “ease aggressively", cutting its overnight cash rate target by between 100 and 150 basis points.

But the bigger problem for Australia could be on the fiscal front, with a global recession likely to result in the budget deficit as a proportion of GDP deteriorating by about 3 percentage points to 4.5 per cent, even before any policy decisions are made.

Implementing the same scale of discretionary fiscal easing as occurred in 2008-09 would therefore lead to the deficit blowing out to about 7.5 per cent of GDP.

“How a small open economy like Australia funds a federal fiscal deficit of that size – especially if the world was dominated by sovereign risk concerns – is an open question in our view," Boyton says.

Which suggests that while Treasurer
Wayne Swan
may be busy showing off his new Euromoney gong to all and sundry in Washington this weekend, his chances of receiving a similar award in the future are exceedingly slim.